How Much Volatility Can You Take?
Building a portfolio can be tricky. On one hand, you may be tempted to take on higher amounts of risk and accept more short-term volatility in exchange for the possibility of higher returns. But it's important to remember that more risk doesn't necessarily guarantee higher returns and can, in fact, bring on higher losses than you're prepared for. Diversification is going to play a large role in determining how much volatility is in your portfolio. Diversifying a portfolio across stocks and bonds (or stock and bond funds) that will behave differently at various points in time can help reduce short-term volatility and it may also help you over the long run.
So how do you decide how much volatility you can take in exchange for the potential of higher end returns? In a simple world, your time horizon (the length of time you're planning on investing to reach a specific financial goal) and your goal would determine how much volatility you can tolerate.
But you're not an emotionless robot who doesn't react to volatility – you're human. As such, it's important to consider how volatility may interfere with meeting your goals, then take positive steps to reduce the factors that lead to volatility in your portfolio. In other words, help limit risk by diversifying across a variety of markets and companies according to your strategy.
Finally, you should ask yourself the following questions to understand and develop your investment philosophy about volatility and risk.
- How much of a loss can you accept from your portfolio each year?
- How much of a loss can you accept over a five-year period?
- How much risk can you accept from your portfolio's individual investments?
- How do you plan to diversify your various investment risks (market, company-specific, economic, and country)?
- What risk-related considerations will an investment have to pass before making it into your portfolio?
Read Next: Determine Your Asset Mix
Keep in mind that while diversification may help spread risk it does not assure a profit or protect against loss in a down market.
Investors should consider the investment objectives, risk, charges and expenses of mutual funds carefully before investing. Mutual funds are subject to market fluctuation including the potential for loss principal. A prospectus contains this and other information about the fund and may be ordered through www.scottrade.com or through a Scottrade branch office. The prospectus should be read carefully before investing.